Fixed income makes comeback

Opinion

Bonds — money investors lend to corporations and governments — have been a relatively raw deal for the last decade, and even more so last year.

For the asset class called ‘fixed income’ that provides steadiness — a counterbalance to the manic up-and downs of the stock market — in portfolios, bonds certainly proved the opposite in 2022.

Consider that the FTSE Canada Universe Bond Index—a measure of most Canadian corporate and government fixed income traded on bond markets—lost nearly 12 per cent.

Typically, this benchmark provides four per cent positive return annually (give or take a couple of percentage points).

Indeed, rising interest rates have beaten up investors’ bond holdings recently.

That’s because their values plummeted to adjust for their low yields that were suddenly far below the high rate of inflation and higher interest rates available for newly issued bonds.

But bonds are poised for a comeback, particularly for investors seeking to add them to their portfolio today.

Indeed, there are likely many investors considering doing so given several of them probably favoured dividend stocks for the last decade as central banks, i.e. the Bank of Canada, kept interest rates low (which kept bond yields low too).

“TINA is dead and has been replaced by TARA — that is ‘there are reasonable alternatives,’” says Tom O’Gorman, Calgary-based director of fixed income for Franklin Templeton Canada.

In TINA, he’s referring to a popular catchphrase over the last several years: ‘There is no alternative.’

This meant that fixed income yields—about two per cent or less—were not providing enough income for many investors (especially retirees).

In turn, their only reasonable alternative were stocks paying dividends that were double the yield of bonds.

Of course, this strategy involved stock market risk, but the alternative was worse. Bond yields were not just unappetizingly low, but they were exposed to the risk of rising interest rates which, as we just saw, can lead to fairly steep losses.

Yet today, fixed income is again a reasonable alternative especially now that the Bank of Canada announced it will pause raising rates for the foreseeable future.

Similarly, the U.S. Federal Reserve is expected to soon put interest hikes on ice to see if inflation falls closer to the desired two per cent per year benchmark.

Sure, central banks could increase interest rates more if inflation remains vexingly high, but it’s unlikely rates would rise like 2022, he adds.

What’s more, with bond yields ranging from about three to five per cent for government issues and higher for corporate bonds, “many investors recognize an opportunity,” says Michael Cooke, director of exchange-traded funds (ETFs) at Mackenzie Investments.

In fact, they began to get wise to fixed income’s upside in the second half of last year.

“It was a really strong year for fixed income flows” into ETFs, he adds, noting $19 billion in net asset creations in 2022.

Still, it can be challenging to wrap one’s head around investing in bonds after seeing the asset class lose more than 10 per cent last year.

“But history does tell us that after a very dramatic move, an attractive entry point for investing often presents itself, where if you have a reasonable timeline, you should be well-rewarded,” Cooke says.

That said, the current environment for bonds is anything but typical.

Short-term bonds — i.e. two-years to maturity — are providing yields around four per cent. In contrast, long term bonds, 10 years or more, are yielding less.

This is not business as usual. Normally, the longer the bond’s maturity, the higher its yield will be.

But today, everything is inverted.

Hence, all the talk about the ‘inverted yield-curve’ where short-term bonds yield more than long-term ones.

Also notable: an inverted yield curve is considered a harbinger of a recession.

“It’s inverted because the bond market is telling us investors don’t believe the interest rate increases will last,” says Alan Fustey, Winnipeg-based portfolio manager.

“Either the economy will slow down, or inflation will slow down.”

Yet there is generally upside to either outcome for bondholders.

Bond values in the portfolio will stay relatively steady—if inflation slows—and could even gain market value if a recession does come, prompting central banks to lower interest rates to stimulate growth.

In short, bonds could be a stabilizing force for portfolios again—counterbalancing falling stock prices with steady yields and even a little growth.

Still, it’s important to be realistic about the upside.

“It’s nice to look at the nominal rate, which is basically the bond’s coupon rate (interest payment) and the yield to maturity,” Fustey says about the annual income bonds provide.

But investors must also understand a bond’s real return. That is its yield minus the rate of inflation.

“Even though interest rates have moved up as high as they have, the real return is still negative,” Fustey explains. So, a bond yield of four per cent—its nominal yield—has a real yield of negative one per cent if inflation is at five per cent.

Of course, real bond yields have been mostly negative for the last decade.

But with central bank interest rates much higher than they have been—and unlikely to increase as rapidly as last year—fixed income has never looked better in the last decade.

“Fixed income offers that (safety) for the first time in a long time,” O’Gorman says.